Can Stocks Hold Up Once Tapering Begins?

A lot has changed since the boom days that preceded the 2008 financial crisis, but two things remain surprisingly similar: corporate profits and stock prices.

Both have returned to record territory, which has been good news for investors. But their recovery has been so rapid and has benefited so much from the Federal Reserve’s intervention that it now poses a challenge: How to keep profits and stocks from sagging once the Fed begins slowly to temper its stimulus, possibly starting this week.

Stock prices and corporate profits stand out because most of the economic backdrop doesn’t look nearly as lush as it did back when the housing bubble was still inflating. The economy is growing again, but it is still limping. Unemployment remains high. The property market is far from recovered.

Stock prices and corporate profits, however, already have risen so fast that the pace of their gains is slowing. This is something that often happens when an economic recovery has been under way for several years; this one has been going since 2009. Something similar happened before the financial crisis, when stocks and corporate profits began running out of steam as the property bubble was deflating in 2007.

The real-estate boom was a big motor for stock gains last time around, but it is a sideshow today. This time, the Fed is a big motor for the market and worries focus on what will happen to stocks as that stimulus begins to shrink.

Making things worse, the Fed is getting ready to move at a time when the economies of countries such as China and India have been struggling, Europe is generating little growth and the Middle East is in turmoil. Nervous investors have withdrawn billions of dollars from both stock and bond funds since mid-August, both in the U.S. and in emerging markets, according to EPFR Global, which tracks such flows.

All of this provides an unsettled backdrop for the Fed pullback. The Fed’s announcement of plans to reduce its bond-buying stimulus could come as soon as Wednesday, after its September policy meeting.

The Fed’s challenge is to carry this off at this delicate moment without provoking an economic slowdown or a selloff in stocks and bonds.

“Why has the Fed kept interest rates near zero for so long?” asks Bank of America Merrill Lynch co-chief economist Ethan Harris. “We’ve had an earnings boom, but economic growth has been slow compared to earnings.”

Twice before, in 2010 and 2011, the Fed has tried to cut back on stimulus, only to see stocks and the economy shudder. Both times, it was obliged to pump fresh money into financial markets. After the Fed pared stimulus in March 2010, the Dow Jones Industrial Average fell 14% between April and July. In 2011, the Dow dropped 17%, with part of the decline coming in anticipation of the Fed move. Each time, the market recovered only after the Fed sent signals that it would resume stimulus.

Now, Fed Chairman Ben Bernanke believes markets and the economy have recovered enough to accept a letup in Fed aid, which he plans to execute very gradually. But the evidence of a recovery isn’t overwhelming. The economy has grown only about 2% a year on average since the recession ended in 2009, Mr. Harris says. Corporate profits have grown 12.7% a year, but that rate has dropped to just 2.1% over the past four quarters.

Corporate profit-growth topped out in a similar way in 2005, before the 2007 stock peak. Today, corporate profits represent 12% of gross domestic profit, the highest level since 1950, Mr. Harris says. It would be exceptional for profits’ share of GDP to move much higher.

Some of the recent stock selling in August and early September reflects a view that stocks are no longer cheap. The Dow is up 135% from its 2009 low and the Nasdaq Composite Index is up 193% in the same period. Some people have sold to lock in gains.

One way to gauge whether stock prices are high is to measure them in terms of corporate earnings. A widely followed price-earnings ratio is calculated by Yale economics professor Robert Shiller, using a 10-year average of corporate earnings. It shows the S&P 500 index at 24 times earnings, well above the long-term average of about 16, but still below the 2007 high of 27.

Conventional p/e ratios tracked by Birinyi Associates show the S&P 500 at about 16 times the previous 12-months’ earnings, below the 17.5 level of 2007.

More worrisome are some gauges tracked by Ned Davis Research. One shows margin debt in brokerage accounts, a measure of the use of borrowed money by investors, is back to levels seen at the 2000 and 2007 peaks. That worries some analysts since it suggests riskier investment are back to the extreme that preceded declines in the past. Another shows cash in money-market accounts down near lows of 2006 and 2007, as a percentage of market value. That suggests investors have less cash available to move into stocks.

Perhaps the biggest positive for markets is that the Fed has far more flexibility today than before the crisis, because inflation is subdued. In early 2006, as the housing bubble popped, the Fed was still raising short-term interest rates to fight inflation. It didn’t begin cutting rates until June 2007, when mortgage-backed bonds already were in turmoil.

Today, low inflation lets the Fed promise to hold short-term interest rates near zero for months to come. Its current plans to cut stimulus involve only its bond-buying program, not any direct changes in its target interest rates. And it even could resume the bond-buying if the economy stumbles.

“Fed policy is vastly different today. It is still treating the financial system as if it is a patient returning from a near-death experience,” says Merrill’s Mr. Harris. “All of this is possible because we don’t have an inflation problem, so the Fed can do a gentle exit.”

Another positive sign is the passage of market leadership to rejuvenated technology stocks from the stocks of financial companies that still haven’t fully recovered from the battering of the financial crisis. At the 2007 stock peak, financial stocks represented more than 20% of total market value. Today, although they have rebounded, they account for about 17% while technology represents around 18%, according to Birinyi Associates. Markets tend to do better when dynamic sectors are dominant.

In 2007, the bond market was sending warning signals. Long-term interest rates were lower than short-term rates, signaling fears of economic weakness. Today, long-term rates are rising and the bond market is signaling the opposite.

The stock market’s problem today is that it has already come a long way. Further gains depend on the Fed continuing to succeed and the world avoiding blowups in Asia, Europe and the Middle East. None of that is guaranteed. But so far, although stocks sank in August, trading volumes were low and selling was far from panicky. The Dow is only 1.8% off its record.

“It is a tired, old advance at this point, but until there is selling pressure I wouldn’t want to bet on a big decline,” said Phil Roth, an independent analyst who foresaw the 2007 top.